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Accessed 07 JULY 2013 http://faculty.philau.edu/lermackh/financial_analysis.htm Steps to a Basic Company Financial Analysis By Professor Harvey B.

Lermack Philadelphia University Philadelphia, PA Revised May 23, 2003 2003 Harvey B. Lermack These are basic steps you may use when evaluating company cases in my graduate and undergraduate business strategy and business policy courses. Before you start, you must understand a couple of things.

This is not meant to be an exhaustive list; there are other steps that can be followed to get deeper into the meaning of the numbers. You cannot analyze the numbers in a vacuum. The numbers only provide indicators to trigger further questions in your mind.
In order to do a thorough job, you must understand something about the companys business and strategies, and its industry. Financial indicators vary from industry to industry; the ratios can only be interpreted when compared and contrasted with other companies in that industry. For example, financial indicators are (and should be) different among financial institutions, manufacturing companies, companies that provide services, and technology and computer information and services companies.

Financial analysis is something of an art. Experienced managers, investors and analysts develop a data bank of information over time, and after doing many such analyses, that they bring to bear every time they review a company.
Step 1. Acquire the companys financial statements for several years. These may be found in your assigned case study; in a recent annual report; in the companys 10K filing on the SECs EDGAR database; or from other sources found at my LINKS website. As a minimum, get the following statements, for at least 3 to 5 years.

Balance sheets Income statements Shareholders equity statements Cash flow statements

Step 2. Quickly scan all of the statements to look for large movements in specific items from one year to the next. For example, did revenues have a big jump, or a big fall, from one particular year to the next? Did total or fixed assets grow or fall? If you find anything that looks very suspicious, research the information you have about the company to find out why. For example, did the company purchase a new division, or sell off part of its operations, that year? Step 3. Review the notes accompanying the financial statements for additional information that may be significant to your analysis. Step 4. Examine the balance sheet. Look for large changes in the overall components of the company's assets, liabilities or equity. For example, have fixed assets grown rapidly in one or two years, due to acquisitions or new facilities? Has the proportion of debt grown rapidly, to reflect a new financing strategy? If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 5. Examine the income statement. Look for trends over time. Calculate and graph the

growth of the following entries over the past several years.


Revenues (sales) Net income (profit, earnings)

Are the revenues and profits growing over time? Are they moving in a smooth and consistent fashion, or erratically up and down? Investors value predictability, and prefer more consistent movements to large swings. For each of the key expense components on the income statement, calculate it as a percentage of sales for each year. For example, calculate the percent of cost of goods sold over sales, general and administrative expenses over sales, and research and development over sales. Look for favorable or unfavorable trends. For example, rising G&A expenses as a percent of sales could mean lavish spending. Also, determine whether the spending trends support the companys strategies. For example, increased emphasis on new products and innovation will probably be reflected by an increased proportion of spending on research and development. Look for non-recurring or non-operating items. These are "unusual" expenses not directly related to ongoing operations. However, some companies have such items on almost an annual basis. How do these reflect on the earnings quality? If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 6. Examine the shareholder's equity statement. Has the company issued new shares, or bought some back? Has the retained earnings account been growing or shrinking? Why? Are there signals about the company's long-term strategy here? If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 7. Examine the cash flow statement, which gives information about the cash inflows and outflows from operations, financing, and investing. While the income statement provides information about both cash and non-cash items, the cash flow statement attempts to reconstruct that information to make it clear how cash is obtained and used by the business, since that is what investors and creditors really care about. If you find anything that looks very suspicious, research the information you have about the company to find out why. Step 8. Calculate financial ratios in each of the following categories, for each year. You may use

the formulas found in your textbook, or other materials you have from your finance and accounting courses. A summary of some useful ratios appears at the end of this document.

Liquidity ratios Leverage (or debt) ratios Profitability ratios Efficiency ratios Value ratios

Graph the ratios over time, to find the trends in the ratios from year to year. Are they going up or down? Is that favorable or unfavorable? This should trigger further questions in your mind, and help you to look for the underlying reasons. Step 9. Obtain data for the companys key competitors, and data about the industry. For competitor companies, you can get the data and calculate the ratios in the same way you did for the company being studied. You can also get company and industry ratios from the Quicken.com Evaluator, Schwab Stock Evaluator, or other locations on my LINKS website. Compare the ratios for the competitors and the industry to the company being studied. Is the company favorable in comparison? Do you have enough information to determine why or why not? If you dont, you may need to do further research.

Step 10. Review the market data you have about the companys stock price, and the price to earnings (P/E) ratio. Try to research and understand the movements in the stock price and P/E over time. Determine in your own mind whether the stock market is reacting favorably to the companys results and its strategies for doing business in the future. Review the evaluations of stock market analysts. These may be found at any brokerage site, or from various locations on my LINKS website. Step 11. Review the dividend payout. Graph the payout over several years. Determine whether the companys dividend policies are supporting their strategies. For example, if the company is attempting to grow, are they retaining and reinvesting their earnings rather than distributing them to investors through dividends? Based on your research into the industry, are you convinced that the company has sufficient opportunities for profitable reinvestment and growth, or should they be distributing more to the owners in the form of dividends? Viewed another way, can you learn anything about their long-term strategies from the way they pay dividends? Step 12. Review all of the data that you have generated. You will probably find that there is a

mix of positive and negative results. Answer the following question:

Based on everything I know about this company and its strategies, the industry

and the competitors, and the external factors that will influence the company in the future, do I think this company is worth investing in for the long term? 2003 Harvey B. Lermack Financial Ratio Analysis (Abridged) Adapted from "Financial Statements Analysis," Courtesy of Professor Philip Russel Philadelphia University Philadelphia, PA A popular way to analyze the financial statements is by computing ratios. A ratio is a relationship between two numbers, e.g. ratio of A: B = 1.5:1 ==> A is 1.5 times B. A ratio by itself may have no meaning. Hence, a given ratio is compared to: Ratios from previous years for internal trends Ratios of other firms in the same industry for external trends. Ratio analysis is a diagnostic tool that helps to identify problem areas and opportunities within a company. , we will discuss how to measure and interpret some key ratios. The most frequently used ratios by Financial Analysts provide insights into a firm's Liquidity Degree of financial leverage or debt Profitability Efficiency Value A. Analyzing Liquidity Liquid assets are those that can be converted into cash quickly. The short-term liquidity ratios show the firms ability to meet its short-term obligations. Thus a higher ratio (#1 and #2) would indicate a greater liquidity and lower risk for short-term lenders. The Rules of Thumb for acceptable values are: Current Ratio (2:1), Quick Ratio (1:1). While high liquidity means that the company will not default on its short-term obligations, one should keep in mind that by retaining assets as cash, valuable investment opportunities may be lost. Obviously, cash by itself does not generate any return. Only if it is invested will we get future return.

1. Current Ratio = Total Current Assets / Total Current Liabilities 2. Quick Ratio = (Total Current Assets - Inventories) / Total Current Liabilities In the quick ratio, we subtract inventories from total current assets, since they are the least liquid among the current assets B. Analyzing Debt Debt ratios show the extent to which a firm is relying on debt to finance its investments and operations, and how well it can manage the debt obligation, i.e. repayment of principal and periodic interest. If the company is unable to pay its debt, it will be forced into bankruptcy. On the positive side, use of debt is beneficial as it provides tax benefits to the firm, and allows it to exploit business opportunities and grow. Note that total debt includes short-term debt (bank advances + the current portion of longterm debt) and long-term debt (bonds, leases, notes payable). 1. Leverage Ratios 1a. Debt to Equity Ratio = Total Debt / Total Equity This shows the firms degree of leverage, or its reliance on external debt for financing. 1b. Debt to Assets Ratio = Total Debt / Total assets Some analysts prefer to use this ratio, which also shows the companys reliance on external sources for financing its assets. In general, with either of the above ratios, the lower the ratio, the more conservative (and probably safer) the company is. However, if a company is not using debt, it may be foregoing investment and growth opportunities. This is a question that can be answered only by further company and industry research. A frequently cited rule of thumb for manufacturing and other non-financial industries is that companies not finance more than 50% of their capital through external debt. 2. Interest Coverage (or Times Interest Earned) Ratio = Earnings Before Interest and Taxes / Annual Interest Expense This shows the firms ability to cover fixed interest charges (on both short-term and long-term debt) with current earnings. The margin of safety that is acceptable varies within and across industries, and also depends on the earnings history of a firm (especially the consistency of earnings from period to period and year to year). 3. Cash Flow Coverage = Net Cash Flow / Annual Interest Expense Net cash flow = Net Income +/- non-cash items (e.g. -equity income + minority interest in earnings of subsidiary + deferred income taxes + depreciation + depletion + amortization expenses) Since depreciation is usually the largest non-cash item in most companies, analysts often approximate Net cash flow as being equivalent to Net Income + Depreciation. Cash flow is a critical variable in assessing a company. If a company is showing strong profits but has poor cash flow, you should investigate further before passing a favorable opinion on the company. nalysts prefer ratio #3 to ratio #2. C. Analyzing Profitability Profitability is a relative term. It is hard to say what percentage of profits represents a profitable firm, as profits depend on such factors as the position of the company and its products on the competitive life cycle (for example profits will be lower in the initial years when investment is high), on competitive conditions in the industry, and on borrowing costs. For decision-making, we are concerned only with the present value of expected future profits.

Past or current profits are important only as they help us to identify likely future profits, by identifying historical and forecasted trends of profits and sales. We want to know whether profits are generally on the rise; whether sales stable or rising; how the profits compare to the industry average; whether the market share of the company is rising, stable or falling; and other things that indicate the likely future profitability of the firm. 1. Net Profit Margin = Profit after taxes / Sales 2. Return on Assets (ROA) = Profit after taxes / Total Assets 3. Return on Equity (ROE) = Profit after taxes / Shareholders Equity (book value) 4. Earnings per Common share (EPS) = (Profits after taxes - Preferred Dividend) / (# of common shares outstanding) 5. Payout Ratio = Cash Dividends / Net Income Note: The terms profits, earnings and net income are often used interchangeably in financial statements. Be sure to review the statements to understand their components. D. Analyzing Efficiency These ratios reflect how well the firms assets are being managed. The inventory ratios shows how fast the inventory is being produced and sold. 1. Inventory Turnover = Cost of Goods Sold / Average Inventory This ratio shows how quickly the inventory is being turned over (or sold) to generate sales. A higher ratio implies the firm is more efficient in managing inventories by minimizing the investment in inventories. Thus a ratio of 12 would mean that the inventory turns over 12 times, or the average inventory is sold in a month. 2. Total Assets Turnover = Sales / Average Total Assets This ratio shows how much sales the firm is generating for every dollar of investment in assets. The higher the ratio, the better the firm is performing. 3. Accounts Receivable Turnover = Annual Credit Sales / Average Receivables 4. Average Collection period = Average Accounts Receivable / (Total Sales / 365) Ratios #3 and #4 show the firms efficiency in collecting cash from its credit sales. While a low ratio is good, it could also mean that the firm is being very strict in its credit policy, which may not attract customers. 5. Days in Inventory = Days in a year / Inventory turnover Ratio #5 is referred to as the shelf-life i.e. how quickly the manufactured product is sold off the shelf. Thus #5 and #1 are related. E. Value Ratios Value ratios show the embedded value in stocks, and are used by investors as a screening device before making investments. For example, a high P/E ratio may be regarded by some as being a sign of over pricing. When the markets are bullish (optimistic) or if investor sentiment is optimistic about a particular stock, the P/E ratio will tend to be high. For example, in the late 1990s Internet stocks tended to have extremely high P/E ratios, despite their lack of profits, reflecting investors' optimism about the future prospects of these companies. Of course, the burst of the bubble showed that such confidence was misplaced. On the other hand, a low P/E ratio may show that the company has a poor track record. On the other hand, it may simply be priced too low based on its potential earnings. Further investigation is required to determine whether the company would then provide a good

investment opportunity. 1. Price To Earnings Ratio (P/E) = Current Market Price Per Share / After-tax Earnings Per Share 2. Dividend Yield = Annual Dividends Per Share / Current Market Price Per Share F. Uses and Limitations of Ratio analysis Uses 1. To evaluate performance, compared to previous years and to competitors and the industry 2. To set benchmarks or standards for performance 3. To highlight areas that need to be improved, or areas that offer the most promising future potential 4. To enable external parties, such as investors or lenders, to assess the creditworthiness and profitability of the firm Limitations 1. There is considerable subjectivity involved, as there is no correct number for the various ratios. Further, it is hard to reach a definite conclusion when some of the ratios are favorable and some are unfavorable. 2. Ratios may not be strictly comparable for different firms due to a variety of factors such as different accounting practices or different fiscal year periods. Furthermore, if a firm is engaged in diverse product lines, it may be difficult to identify the industry category to which the firm belongs. Also, just because a specific ratio is better than the average does not necessarily mean that the company is doing well; it is quite possible rest of the industry is doing very poorly. 3. Ratios are based on financial statements that reflect the past and not the future. Unless the ratios are stable, it may be difficult to make reasonable projections about future trends. Furthermore, financial statements such as the balance sheet indicate the picture at one point in time, and thus may not be representative of longer periods. 4. Financial statements provide an assessment of the costs and not value. For example, fixed assets are usually shown on the balance sheet as the cost of the assets less their accumulated depreciation, which may not reflect the actual current market value of those assets. 5. Financial statements do not include all items. For example, it is hard to put a value on human capital (such as management expertise). And recent accounting scandals have brought light to the extent of financing that may occur off the balance sheet. 6. Accounting standards and practices vary among countries, and thus hamper meaningful global comparisons.